Finance in a Theory of the Business Cycle: Production and Distribution in a Debt and Equity Economy

This innovative book presents an original integration of finance into business cycle theory. Robert Krainer begins with a selective review of the major 20th-century theories of macroeconomic fluctuations: the classical model of economic equilibrium under uncertainty, the IS-LM model of income determination that came to challenge the classical system and the new classical model that in turn challenged the IS-LM system. He also reviews two recent developments, namely real business cycle theory and the new Keynesian models based on monopolistic competition. With this background, the major part of the book offers a new view of how the financial system co-ordinates real activity. Nominal or real shocks change equity investors' required yield on shares by altering their risk aversion. This change in equity yield affects the capital market value of the firm which is itself the signal for managers to change the risk of the firm's operating strategy. This change in the risk of the firm's operating strategy is then matched with an appropriate financial strategy that is designed to coalesce the welfare of stockholders and bondholders. The pricing, employment, output, investment and financing decisions managers implement in this dynamic coalescing process then shape the so-called stylized facts of business cycles. The author goes on to test the theory that financial and operating decisions of firms are systematiclly linked together, using US data. He also describes the actual institutional practices of financial contracting by which risk and return are shared within the firm. The concluding chapter indicates possible directions for future research.